Since bottoming at the end of October, the MSCI Emerging Market Index (MXEA) and MSCI Asia Ex-Japan ...
Time to Buy into China and Brazil?
11/18/2011 8:00 am EST
These 2 emerging markets have been outpacing the US market for a month—that’s a trend that could make us some money. Here’s why it’s almost time to buy in.
It’s early. The results are open to revision and interpretation. And one month doesn’t make an investable trend any more than a single swallow makes a spring.
But have you noticed? In the past month, emerging stock markets, such as China and Brazil, have outperformed the US market.
And that’s an absolute turnaround from results in 2010 and for most of 2011.
Does it mean that we’re about to reverse the pattern that’s held for more than a year and see emerging markets start to outperform developed markets? Well, sort of.
The picture right now shows that the outperformance is limited to some emerging markets, and even in those markets, the outperformance is spotty. But I think there’s the beginning of a trend here that your portfolio needs to respect.
And because it’s so early, you need to pay attention to what kinds of stocks in these emerging markets investors are willing to buy right now.
Here’s the data:
- US markets: For 2010, the S&P 500 was up 15.02%. For 2011, as of November 15, the S&P 500 was up 1.65%. In the past three months, it gained 5.05%. In the past month, 2.85%.
- Brazil: For 2010, the iShares MSCI Brazil Index ETF (EWZ) was up 7.69%. For 2011, as of November 15, it was down 19.54%. In the past three months, the loss was a more modest 2.80%. In the past month, the index climbed 4.35%.
Yep. In the past month, the Brazil index beat the US market. After trailing for 2010. After getting killed in 2011 to date. After trailing badly over the past three months.
China shows the same pattern—with some important wrinkles.
In 2010, the SPDR S&P China ETF (GXC) was up 7.58%. For 2011, as of November 15, it was down 11.31%. For the past three months, the loss was 5.13%. And in the past month, the index climbed 4.77%.
In other words, exactly the same pattern as Brazil—well behind the US market until the past month, and then outperformance. Significant outperformance. We’re talking a 2.85% gain for the US index versus 4.35% for Brazil and 4.77% for China.
Bigger Is Better
One interesting wrinkle is that you could have done even better investing in China recently if you’d picked a different index.
If instead of the SPDR S&P China, with its 4.77% gain in the past month, you had invested in the iShares FTSE China 25 Index ETF (FXI), you would be looking at a 9% gain in the past month. (And a much lower 0.76% loss over the past three months, too.)
What’s made the big difference in the gains from the two indexes? Size, in my opinion.
The average stock in the very concentrated FTSE China 25 Index has a market capitalization of $72.6 billion, according to Morningstar. These are huge companies—and indeed, Morningstar categorized 92.4% of the index holdings as "giant." (This isn’t exactly a surprise; the mandate of the index is to invest in the 25 largest Chinese companies listed in Hong Kong.)
The average stock in the SPDR S&P China Index isn’t a small cap by any means (although the index does include a 0.43% weighting of small-cap stocks and even a 0.19% weighting of microcaps). But the average holding is a smaller (if still very large) $27.7 billion.
Only 61.2% of holdings qualify as giant, according to Morningstar. The index even includes an 8.2% weighting to stocks that qualify as midcap. (The index is a market-cap-weighted index of 130 stocks that trade in Hong Kong, or as US-listed ADRs, or are listed on the New York Stock Exchange.)
There’s isn’t a similar big and bigger index pair for Brazil. But comparing the gains of the iShares MSCI Brazil Index with those of the iShares MSCI Brazil Small Cap Index (EWZS) makes a similar point: Size matters very much right now.
In the month ended November 15, the small-cap Brazilian index (the average market cap of its holdings is $776 million) showed a 2.28% gain to the 4.35% gain for the iShares MSCI Brazil Index (average market cap: $21 billion). Only 22.2% of that index is made up of midcap companies, and a tiny 2.2% consists of small-cap stocks.
NEXT: Why Size Matters|pagebreak|
Why Size Matters
Why the discrepancy between big- and small-cap performance in Brazil and China as these markets show signs of moving out of the downturn that has ruled them since they peaked back in November 2010?
A couple of factors explain it, I think.
First, the early cash flow moving into Brazil and China is dominated by institutional investors who:
- favor big stocks when they put money to work, because they want to be able to deploy substantial cash without raising the price of the stock they’re buying (until they’re done buying).
- want to make sure they can get out as easily as they got in.
Think it might be easier to move in and out of Petrobras (PBR), with its $173 billion market cap and US ADR, than Kroton Educacional (KROT11, in Brazil) with its $968 million market cap and no US listing?
All else being equal—though of course, it’s not when you compare an oil company with an education company—size explains why Petrobras is up 8.9% in the past month and Kroton Educacional is down 0.06%.
Second, banks. Financials aren’t always a leading sector when a stock market rallies, but I think they’re likely to be if China and Brazil are indeed headed for a period of outperformance. That’s because in the case of both of these markets, actual or anticipated interest-rate cuts from central banks are a big part of the force behind these rallies.
The Banco Central do Brasil has already started to reduce interest rates in order to get its economy moving faster—and economists anticipate another rate cut (or maybe two) in 2011.
In China, the People’s Bank is perhaps as much as six months away from an interest-rate cut. First, the central bank has to unwind a few of the nine increases in bank reserve requirements it put into place since October 2010. Second, it needs to be sure the official inflation rate is headed below 5%, on its way to the official target of 4%.
But interest-rate cuts are on the way. Banks are an immediate beneficiary of rate cuts, because they see the cost of the funds that they will lend out fall while the interest rates they charge borrowers remains high. Net interest spreads go up, and that goes straight to the banks’ bottom line.
Banks and other financial companies with investment portfolios get an additional benefit: As asset prices go up in any market rally produced by interest-rate reductions, the value of the assets in their portfolios rises as well.
Don’t Be Too Sure
Wednesday’s big sell-off in emerging-market stocks was a reminder that these markets and this trend aren’t anything like sure things.
For stocks to go up in China and Brazil, the level of fear in the financial markets doesn’t have to disappear, but it has to be contained. If the euro crisis is just bubbling along, threatening to engulf Greece—as has been the case for the past month—then I think Brazil and China can outperform.
If the euro crisis ratchets up so that investors are worried about contagion reaching France, then I think everything goes down—and emerging markets such as China and Brazil go down harder than the US market.
These financial markets remain more volatile than their developed-economy counterparts. That’s great when the volatility is to the upside, but frightening when it isn’t.
Still, I think the emerging outperformance of the emerging markets of Brazil and China is real. And I think you should be adding these stocks to your portfolio.
But we’re in for an extremely volatile couple of weeks as we wait for the European Central Bank to figure out that, like it or not, it is the buyer of last resort in the European sovereign debt market.
And then, don’t forget the volatility that results as we watch the US Congress thrash around at funding the US government—there’s a deadline for that on Friday—and at reducing the US budget deficit, for which November 23 is the deadline.
When some of that storm has passed, I’ve got a candidate for the early stages of Brazilian outperformance already teed up in my watch list. That’s big Brazilian bank Itau Unibanco (ITUB). And with this column, I’m adding Chinese insurer Ping An (PNGAY) to my watch list.
Ping An was down 28.66% for 2011 as of November 15, but up 13.43% for the past month. That’s exactly the kind of pattern I’m looking for, but I’m not ready to put the stock in Jubak’s Picks. Not yet.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Itau Unibanco and Ping An as of the end of September. For a full list of the stocks in the fund as of the end of September, see the fund’s portfolio here.
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